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How Investors Turned Into Gamblers

The continuing interest in leveraged ETFs is troublesome.

You'd think that after getting burned by a product, investors would learn their lesson and move on. Yet time after time, it seems that many investors fall into the same traps, and Wall Street is only too happy to let them keep repeating their mistakes.

Leveraged ETFs are a great example of this phenomenon. In recent years, the dangers of these vehicles to long-term investors have revealed themselves countless times. Yet despite repeated warnings about them, new leveraged ETFs continue to come out, and many investors will inevitably learn the hard way about their potential pitfalls.

Ignoring the regulatorsTwo pieces of news I saw yesterday seemed almost perfectly timed for irony. On one hand, the SEC issued a bulletin earlier this week that discussed the difficulties and complexities of investing in ETFs, with a particular focus on leveraged ETFs that offer double exposure to movements in certain markets. Referring back to an earlier investor alert, the SEC noted that because these ETFs typically reset on a daily basis, they don't always work well for longer-term investors.

Yet the SEC's warnings haven't kept ETF providers from coming out with new leveraged products to meet investor demand. Direxion just announced it would come out with four new leveraged ETFs aimed at tracking the Dow Jones Industrial Average(INDEX: ^DJI), with two bullish funds and two bearish funds offering double and triple exposure to the Dow's daily movements. It plans to offer a cost advantage compared to similar funds from ProShares, with expenses of just 0.75% compared to 0.95% for ProShares Ultra Dow30(NYSE: DDM) and ProShares UltraShort Dow30(NYSE: DXD).

If leveraged ETFs are so bad, why do ETF companies keep coming up with new ones? Some possible answers make sense, but they strongly suggest that people aren't willing to be patient with their investing strategies anymore.

Making up for lost timeOne possible explanation for interest in leveraged ETFs comes from the fact that most workers are woefully unprepared for their looming retirement years. With many retirees having only a fraction of what they need to retire comfortably, they're looking for shortcuts to amass wealth. At a glance, leveraged ETFs appear to provide that sort of exposure, and because near-retirees are willing to take risk in order to catch up with their retirement nest eggs, warnings about leveraged ETFs typically fall on deaf ears.

Yet countless times, warnings about leveraged ETFs have proven true. With silver's big drop over the past year, you might expect that bearish leveraged silver ETFs might have produced some strong gains. Over the past year, though, ProShares UltraShort Silver(NYSE: ZSL) has actually fallen very slightly, while the bullish ProShares Ultra Silver(NYSE: AGQ) has predictably gotten crushed, losing more than 60% of its value.

The other explanation for investor interest in leveraged ETFs actually indicates a greater understanding of the products yet raises the same concerns: Many people may well have simply given up on long-term investing entirely and are looking solely to short-term trading to try to earn profits from their portfolios. Although that strategy at least matches up with the exposure that leveraged ETFs provide, it indicates that investors have given up on prudent strategies in favor of what's no better than gambling.

Don't give upLong-term investing is difficult because it requires something that many investors don't have much of right now: patience. Even after a massive rebound from 2009's stock market lows, many investors are still waiting to match their net worth from five years ago. Moreover, with analysts getting increasingly nervous about how long the bull market can sustain itself, it's tempting to give up on buy-and-hold investing in favor of seeking a quick buck.

Despite the need for discipline, though, thinking about the long run is the best way to avoid losing everything. By contrast, it's far too easy to end up with losses from leveraged ETFs that you'll never recover from.

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Author

Dan Caplinger has been a contract writer for the Motley Fool since 2006. As the Fool's Director of Investment Planning, Dan oversees much of the personal-finance and investment-planning content published daily on Fool.com. With a background as an estate-planning attorney and independent financial consultant, Dan's articles are based on more than 20 years of experience from all angles of the financial world.
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